International Financial Management

1. InternationalFinancial Management Parity Conditions in International Finance

2. Agenda • Introduction • Price Levels, Inflation and Exchange Rates • Exchange Rates and Interest Rates • Forward Market • Covered Interest Rate Parity • Summary

3. Introduction • When it comes to economic decisions which have long run ramifications like locating a subsidiary, two problems have to be dealt with: • The foreign currency revenue in that market has to be estimated. • The rate at which the foreign currency revenue can be translated into home currency needs to be forecasted.

4. Notation

5. Purchasing Power Parity - Example • Example: Export one Apple computer from the US to Japan.

6. Purchasing Power Parity - Example • Initially, the law of one price holds: • What would the future exchange rate have to be for an exporter to be indifferent between where to ship the computer? • What has happened to the exchange rate?

7. Relative Purchasing Power Parity

8. Purchasing Power Parity - Example • If RPPP holds, changes in nominal exchange rates will fully compensate for differences in inflation across countries. • Suppose that the ¥ does appreciate, but by less than 2.0% (the inflation differential), e.g., • Where would you prefer to sell the computer?

9. Purchasing Power Parity - Example • The result is a real ¥ depreciation. Toshiba computers and other Japanese exporters have become more competitive. • They can afford to lower the $ price, and still get more ¥ revenue from the sale of a computer in the US than in Japan. • Real exchange rate changes affect firms’ competitiveness in global markets.

10. Real Exchange Rate Changes • How can we measure this change in perceived competitiveness? • Compare the actual spot exchange rate at the end of the year (¥119/$) with the one that would have prevailed at the end of the year if RPPP held: • We actually pay more ¥/$ (119) than we would have if the ¥ appreciated to reflect the 2.0% inflation differential. • ¥ has experienced a REAL DEPRECIATION versus the dollar. • $ has experienced a REAL APPRECIATION versus the ¥.

11. Relative Purchasing Power Parity-Take Two (direct quotes) Rate of increase in $ costs for US exporter Rate of increase in $ value of ¥ Rate of increase in ¥ revenue for US exporter

12. Deviations from RPPP • It follows that: • q = 1 => RPPP holds • Inflation differentials are off-set by changes in nominal exchange rates. • q < 1 => competitiveness of US improves • Increase in dollar costs is less than the increase in the dollar value of foreign currency revenue • q > 1 -> competitiveness of US deteriorates • Increase in dollar costs exceeds the increase in the dollar value of foreign currency revenue

13. The Big Mac Index • Beefed up • Jul 5th 2007From Economist.com • OUR Big Mac Index provides a rough guide to how far currencies are from fair value. The index is based on the theory of purchasing-power parity (PPP), which says that exchange rates should equalise the price of a basket of goods—in this case, a Big Mac hamburger. • The implied PPP is the exchange rate that makes the dollar price the same in each country. • Using this yardstick, China's yuan is the cheapest currency. A Big Mac in China costs 11 yuan, or $1.45, an undervaluation of 58%. However, local inputs such as rents and wages tend to be lower in poorer countries and less easily arbitraged across borders, so PPP is a better guide to misalignments between countries at a similar stage of development. • Most rich-world currencies are overvalued against the dollar, including the euro (by 22%) and the Swiss franc (by 53%). The yen is an exception, but although it is undervalued by 33% in Big Mac terms, broader PPP measures would suggest that it is close to fair value.

16. The Big Mac Index • The Big Mac Index and McParity (application of LOP) • On July 5, 2007 (The Economist) • Big Mac costs $3.41 in the US • Big Mac costs $1.45 in China • Implied exchange rate => Yuan11=$3.41*Yuan3.23/$ • Actual exchange rate, S(Yuan/$) = 7.60 • The yuan is undervalued relative to the dollar (burger too cheap!)  McPrediction: S(Yuan/$) should .  US dollar should depreciate against the yuan, or the yuan should appreciate against the dollar  On January 8, 2008, S(Yuan/$) = 7.2693 

17. The Big Mac Index • The Big Mac Index and McParity (application of LOP) • On May 25, 2006 (The Economist) • Big Mac costs $3.41 in the US • Big Mac costs $5.20 in Switzerland • Implied exchange rate => CHF6.30 = $3.41*CHF1.85/$ • Actual exchange rate, S(CHF/$) = 1.21 • The CHF is overvalued relative to the dollar (burger too expensive!)  McPrediction: S(CHF/$) should .  US dollar should appreciate against the CHF, or the CHF should depreciate against the dollar  On January 8, 2008, S(CHF/$) = 1.1145 

18. Yen and yangSep 28th 2006 | HONG KONGFrom The Economist print edition

19. Relative Purchasing Power Parity • Does relative purchasing power parity hold? • Commodity basket • Horizon • Inflationary situation • Exchange rate regime/capital controls • What factors make the theory difficult to test?

20. Exchange Rates and Interest Rates • Can we link exchange rates to interest rates? Consider first a mechanical definition: • The Fisher relation says that the nominal interest rate equals the real interest rate plus inflation: • With free capital flows and no uncertainty, real interest rates would be the same in the US and in Japan.

21. Exchange Rates and Interest Rates • With free capital flows, no uncertainty, and no arbitrage (UIP):

22. Does this make sense? • Suppose you have $10 million to invest, and that you can invest either in Japan at i¥ or in the US at i$ • If you invest in the US, at the end of the year you will have: • $10m*(1+ i$) • If you instead invest in Japan, you will first have to buy Y: • $10m*S0(¥/$) • Then invest the ¥ to get: • $10m*S0(¥/$)*(1+i¥), ¥ at the end of the year • Finally, you have to sell the Y for $ at the end of the year: • $10m*S0(¥/$)*(1+i¥)/S1(¥/$) • If the US interest rate exceeds the Japanese interest rate, what do you think will happen to the yen over the course of the year?

23. The “carry trade”

24. The “carry trade” • Borrow low interest rate currencies (¥, SEK, CHF), and invest in high interest rate currencies (US$, NZ$, AS$). • Interest Rate Parity (direct quotes):

25. The so called carry trade

26. The so called carry trade Constant and low interest rates starting 2001 made the carry trade popular

27. The so called carry trade • Interest rates are still super low in Japan (0.7%) compared to the US (4.0%) and Europe (4.7%). • Moreover, the BOJ is not expected to aggressively raise interest rates. • Even if the Bank of Japan holds rates steady - as it is widely expected to do - a rise in the yen itself could spark a self-sustaining unwinding of the carry trade

28. The so called carry trade

29. Exchange Rate Determination • Factors that are important for determining exchange rates: • Relative inflation rates (high inflation bad) • Relative real interest rates (high real rates good) • Relative GDP growth rates (high growth good) • Trade balance (Exports-Imports > 0 good) • J-curve effect • Exchange rate depreciation • Initial deterioration in TB (Imports more expensive) • Eventually, TB improves (Exports take off) • Future GDP growth => Exchange rate appreciation??? • Unfortunately, academic research has very little to say about the determination of exchange rates in the short run. • In the long run (5-7yrs), we believe that exchange rates are linked to real interest rates, economic growth, and inflation rates.

30. The Forward Market • A forward contract is an agreement between two parties about the delivery, at a fixed future date, of a specified amount of currency, at a pre-specified price: the forward rate. F30(¥/$) = 118.049 • Maturities on the most commonly quoted contracts are 30, 60, 90, 180, or 360 days.

31. The Forward Market • Often, forward rates are quoted as swap rates, which is defined as (based on mid-points): swap = F30(¥/$) - S(¥/$) = 118.049 - 118.585 = -0.536 • If the swap rate is positive, the ¥ is said to be trading at a forward discount. If the swap rate is negative, the ¥ is said to be trading at a forward premium.

32. Covered Interest Rate Parity • Suppose that a Japanese firm needs to pay $1 in one year. • Alternative 1: • invest: $1/(1+i$) today • costs: $1*S(¥/$)/(1+i$) today • Alternative 2: • forward contract: $1*F(¥/$) one year • Covered interest rate arbitrage: • $1*S(¥/$)/(1+i$) = $1*F(¥/$)/(1+i¥) today

33. Covered Interest Rate Parity

34. Forward Market http://www.ft.com

35. Covered Interest Rate Parity Japanese Yen mid-point: 0.835 US Dollar mid-point: 4.445

36. Covered Interest Rate Parity – Try it!

37. Covered Interest Rate Parity • The forward rate is the ¥ price today of dollars delivered tomorrow. • The forward rate differs from the current spot rate because of the time-value of money. • The forward rate conveys no additional information about conditions expected in the future than what is already incorporated in the current spot rate and the current interest rate differential!!!

38. Wrap-Up • If relative purchasing power parity holds, any change in relative price levels between countries is reflected in an adjustment of the nominal exchange rates. Thus, nominal exchange rate changes have no implications for competitiveness. • Deviations from purchasing power parity do have implications for the competitiveness of a country’s exports industry. • In practice, short to medium term deviations from relative purchasing power parity are to be expected.

39. Wrap-Up • By contrast, Covered Interest Rate Parity does hold. It is pinned down by arbitrage. • While it is tempting to conclude that the forward rate is a predictor of future spot exchange rates, this is not true. • There is no additional information in the forward rate that is not already included in the spot exchange rate and the domestic and foreign interest rates!